One must note carefully that this is an exercise in abstract neoclassical and Austrian economics theorising, not empirical economics: for the Wicksellian natural rate of interest cannot even be defined outside of a world with one commodity (see Rogers 1989: 32 with n. 6; 43) – so from the beginning Hicks missed one of the fatal flaws in Hayek’s theory because of his neoclassical background.
Hicks remembered that Hayek’s theory got considerable traction in the 1930s and was even, at one point, a rival to Keynes’ (Hicks 1967: 203).
Keynes had published his Treatise on Money in 1930, and Hayek gave his famous lectures at the London School of Economics (LSE) from February 1931, and the first edition of Prices and Production was published in September 1931 – at a time when the world was hit by the Great Depression and there was growing interest in theories of the business cycle (Hicks 1967: 204).
Both Keynes and Hayek were intellectual heirs of Wicksell: but each had come to different conclusions on economic issues and policy prescriptions (Hicks 1967: 204).
Hicks thinks that Hayek in his Wicksellian model made the assumption that prices (including wages) were “perfectly flexible” (Hicks 1967: 206), but this assumption made his whole theory incoherent, because if prices were flexible and even if the bank rate fell below the Wicksellian natural rate, then price adjustments to clear markets would bring the whole system back into equilibrium quickly.
As Hicks said:
“Thus there is no room for a prolonged discrepancy between market rate and natural rate if there is instantaneous adjustment of prices. Money prices will simply rise uniformly; and that is that.” (Hicks 1967: 207).Hicks considers what would happen in Hayek’s theory, as follows:
(1) a credit expansion and reduction of the market rate of interest below the Wicksellian natural rate;But Hayek’s theory, again according to Hicks, does not allow step (4): despite wage rises, demand for consumption goods fails to rise and consumer goods’ prices do not rise (Hicks 1967: 208). There must therefore be a lag in consumption after money wages rise.
(2) real investment rises, which causes a rise in producers’ goods prices;
(3) money wages rise;
(4) consumption rises and consumer goods’ prices rise, but the rise in prices will (according to Hicks) dampen the excessive real investment, so that there is a “nil effect” (Hicks 1967: 207–208).
Whether Hicks really understood Hayek’s ABCT and the intricacies of Austrian capital theory is open to debate, and Hayek responded to Hicks in the article “Three Elucidations of the Ricardo Effect” (1969).
In this, Hayek replied to Hicks that disequilibrium in relevant product markets continues because of the continuous “inflow of new money” into the system “at a given point and at a constant percentage rate” (Hayek 1969: 279). Though this concedes Hicks’ point that a “single non-recurrent” injection of new money would only have transient economic effects, Hayek maintained that his theory involves long-term and continuous injections of new money (Hayek 1969: 279–280). Moreover, Hayek’s theory does assume Cantillon effects and certain lags in price adjustment.
But there is an interesting issue here: the price and wage rigidities and the ABCT.
Under the simplistic model of Austrian and neoclassical theory, if prices and wages really were perfectly flexible (and all sorts of other problems with expectations, uncertainty and fixed nominal debt were assumed away), then the rise in consumer goods’ prices would cause less demand for such goods, and demand would fall and savings would increase, making a space for the higher order capital investments originally induced by the lowering of the bank rate of interest below the Wicksellian natural rate.
Likewise, the rise in factor prices would dampen demand for them, returning equilibrium to those markets. That is, I suppose, what Hicks was thinking of here: that wage and price flexibility and the law of demand would cause the Wicksellian natural rate to adjust and actually fall to the bank rate.
Vasséi (2010: 213) seems to make a similar neoclassical criticism of Mises’ business cycle theory.
Unfortunately, all this is like arguing about how many angels can fit on the head of a pin: ultimately, it is of very little interest to an empirical economics concerned with the real world, rather than unrealistic abstract models.
Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.
Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.
Hayek, F. A. von. 1969. “Three Elucidations of the Ricardo Effect,” Journal of Political Economy 77.2: 274–285.
Hicks, J. R. 1967. “The Hayek Story,” in J. R. Hicks, Critical Essays in Monetary Theory, Clarendon Press, Oxford. 203–215.
O’Driscoll, Gerald R. Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek. Sheed Andrews and McMeel, Kansas City.
Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.
Vasséi, Arash Molavi. 2010. “Ludwig von Mises’s Business Cycle Theory: Static Tools for Dynamic Analysis,” in Harald Hagemann, Tamotsu Nishizawa, Yukihiro Ikeda (eds.). Austrian Economics in Transition: From Carl Menger to Friedrich Hayek. Palgrave Macmillan, Basingstoke. 196–217.